The Great American Jobs Act Caper

How the American Jobs Creation Act of 2004 changed not just the rules but the US mindset for taxing international income is discussed. For the first time in more than forty years, major tax legislation encourages US companies to earn low-taxed income abroad. In the name of correcting abuses, the Act granted complete exemption to both past and future foreign earnings of domestic companies that... (see full summary)

This Article discusses how the American Jobs Creation Act of 20041 changed not just the rules but the U.S. mindset for taxing international income. For the first time in more than forty years, major tax legislation encourages U.S. companies to earn low-taxed income abroad. This could not more repudiate the legacy of Stanley Surrey, whose 1961 tax thinking under President Kennedy became 1986 tax legislation under President Reagan.2

Surrey, Treasury's top tax policy official during the Kennedy and Johnson era,3 believed that income earned abroad by foreign subsidiaries of U.S. parents should be taxed as if earned directly. The alternative, which postpones inclusion of the earnings until they are distributed to the parent as a dividend, is known as deferral. The ability to defer tax on income can have considerable value.4 Eliminating that value by ending deferral would remove any tax incentive to invest in low-tax foreign countries and hire their workers.

The association of low-taxed earnings from U.S. investment abroad with loss of U.S. jobs has considerable resonance.5 To muffle that, the Jobs Act uses its title to appropriate the goal of the very tax policy it scuttles. That purpose, keeping business activity here, informs its approach to the related issues of deferral, credit for foreign tax, and the taxation of exports. In each of those contexts, the rejected mindset views the issue as whether U.S. companies manufacture here or export their capital and manufacture abroad.6 Since its intent is to take tax imbalance out of that competition, the view often is referred to as capital export neutrality.

The opposing view, capital import neutrality, thinks the relevant competition takes place among different countries. To illustrate, Singapore might grant a tax exemption for capital imported into that country to manufacture slings. Any local Singapore company will not pay any tax on the profits. But if a U.S. parent would pay tax on them at some time, whereas a European parent would not, Europe can undercut the United States not only as to slings sold in Singapore but everywhere else, including the United States. Accordingly, capital import neutrality wants to help the United States compete worldwide by taxing foreign earnings as lightly as possible.

The Act7 did not invent capital import neutrality, with which its adherents bedeviled Surrey; and it may well have more force now than in the 1960's. But this Article does not intend to evaluate economic theories.8 What it does intend to do first is to point out the obvious: that encouragement of earning low-taxed income abroad has been cast as the creation of U.S. jobs. Next, the Article tries to show how-with what complexity and subtlety-the Act has done this. In that attempt, it pictures the Act as completing a trilogy, the three-part unraveling of a forty-year run. That run started with the Revenue Act of 1962,9 and lasted until the Jobs Act undid the Tax Reform Act of 1986.10

The title of the Jobs Act misleads in a second way, so vital and obvious that it provokes wonder at the audacity to give it that name. The Act's origin traces back to 2002, when the World Trade Organization (WTO) decided that a Code provision exempting export profits from tax gave American manufacturers an illegal advantage in competing abroad.11 The WTO decision that the United States had violated its trade agreement allowed EU countries to retaliate against U.S. exports by imposing discriminatory tariffs. That right continues so long as ETI remains in force. EU countries retaliated ingeniously, by ratcheting up tariffs against U.S. exports produced in states pivotal to the 2004 Presidential election-for example, oranges. Producers of retaliated-against goods protested, and this ultimately forced Congress to repeal most of ETI.12 The genesis and a central provision of the Act aimed at wncreating American jobs.

Congress tried to staunch the competitive damage. Tweaking the export benefit and renaming it had failed twice,13 so as compensation it slightly reduced the corporate tax rate on all goods manufactured in the United States.14 This could not begin to compensate a national export trade asset like Boeing. A recent Supreme Court case that concerned only the amount of Boeing's airplane development expense allocable to ETI involved $419 million in tax.15 In addition, the Act purported to encourage U.S. competition by allowing both the future accumulation of low-taxed foreign earnings and virtual exemption from tax of those already accumulated. The House Ways and Means Committee report describes both as though they had the same effect:

The Committee also believes that it is important to use the opportunity afforded by the repeal of the ETI regime to reform the U.S. tax system in a manner that makes U.S. businesses and workers more productive and competitive than they are today. To this end, the Committee believes that it is important to provide tax cuts to U.S. domestic manufacturers and to update the U.S. international tax rules, which are over 40 years old and make U.S. companies uncompetitive in the United States and abroad.16

But neither makes up for the injury to some significant U.S. exporters, and the exemption of accumulated foreign earnings widens a disadvantage of exporters that operate (and employ people) primarily in this country. Neither the WTO nor the Act focused on the distinctly different tax positions of U.S. exporters. The first-like Boeing, which vigorously opposed ending ETI-have few or no operations abroad.17 The second, like Intel Corporation, operates and often pays considerable foreign tax abroad.18

The first group used ETI to exempt export profits from tax, and repeal will stop that. The second group uses the foreign tax credit to exempt export profits from tax, and ETI repeal will not hurt them at all. In fact, the Act gives them a new tax advantage over exporters who needed ETI. Moreover-and quite moreover-the Act adds a one-time provision that effectively exempts from U.S. tax the distribution of low-taxed earnings accumulated in foreign subsidiaries.19 This frees foreign tax credits that otherwise would be used up against those old earnings to exempt new export profits from tax.20

The name of the law, then, as well as some of its legislative history, recall what Mary McCarthy said of Lillian Hellman: "Every word she writes is a lie-including 'and' and 'the.'"21

II. BACKGROUND

A. From Surrey to Reagan

Ending deferral was not unique or original to Surrey. But under Surrey the government first proposed it for public companies, and the proposal succeeded as to certain low-taxed income.22 This encountered substantial business opposition, which spilled over to the personal.23 Yet the Reagan Treasury, which never even dreamed of ending deferral, likewise expressed concern about "an incentive to invest in low-tax countries;"24 and the Tax Reform Act of 1986 limited such incentive25 by expanding the scope of distinctions Surrey had used in the Revenue Act of 1962.

For purposes of entitlement to deferral, the 1962 Act for the first time divided foreign income into categories. It distinguished active business income from passive income, and high-taxed from low- or untaxed income. That act also used distinctions to curtail a tax advantage of earning interest from deposits in foreign rather than domestic banks. In determining the amount of foreign tax credit, it walled off low-taxed foreign bank deposit interest from other income.26 High foreign tax paid on other income no longer could be used to offset U.S. tax on that interest. Since U.S. corporations thereafter would incur the same tax regardless of where money was deposited, the competitive tax advantage of foreign banks disappeared.

The 1986 Act increased the number of distinctions, or categories; used them in determining entitlement to both deferral and the foreign tax credit; and for the most part conformed treatment in one context to treatment in the other.27 By simplifying the categories, which is to say mostly obliterating them, the Act undoes much of 1986. It merges active with passive income: high- with low-taxed income; and it even breaches Surrey's initial, vestigial wall around bank deposit interest.

B. The View from the Sixties

1. Undertaxation Abroad and Jobs at Home

The 1960's Treasury saw U.S. multinationals as undertaxed abroad, although the then U.S. corporate tax rate of around 50%28 set a stiff standard. Two factors, each outdated, underlay that thinking. One was the utter dominance of U.S. business. The other was the physical nature of wealth, which took the form of auto plants and steel mills. The two coincided, since American dominance arose from the physical destruction of Europe and Japan. And when the Treasury proposal to end deferral stalled, both shaped the resulting compromise.

President Kennedy originally proposed to end deferral because, despite American primacy, he (through Surrey and perhaps his chief economist Walter Heller) saw undertaxation abroad as threatening domestic jobs. The 1961 presidential tax message to Congress explained why deferral should end:

Profits earned abroad by American firms operating through foreign subsidiaries are, under present tax laws, subject to United States tax only when they are returned to the parent company in the form of dividends. In some cases, this tax deferral has made possible indefinite postponement of the United States tax; and, in those countries where income taxes are lower than in the United States, the ability to defer the payment of U.S. tax by retaining income in the subsidiary companies provides a tax advantage for companies operating through overseas subsidiaries that is not available to companies operating solely in the United States. . . .